Fed rescue of economy is complex; is it wise?

Tuesday

May 12, 2020 at 6:13 PM

In its scramble to save the American economy, the nation’s central bank seems to have the ultimate superpower. With a few strokes on a computer, the Federal Reserve can create dollars out of nothing, virtually “printing” money and injecting it into the commercial banking system, much like an electronic deposit.

By the end of the year, the Fed is projected to have bought $3.5 trillion in government securities with these newly created dollars — one of many tools it is using to help prop up the ailing economy during the COVID-19 pandemic, according to Oxford Economics.

“The way you and I have checking accounts in our banks, that’s how all these other banks have accounts at the Fed,” said Pavlina Tcherneva, an economist at Bard College in New York. “All the Fed does is literally credit them. They just type it in.”

The Fed’s goal: to keep markets functioning after they had seized up in fear. The strategy also makes credit easier to obtain through a bigger money supply and lower interest rates. Without these and the Fed’s other emergency measures, the economy would have crashed, experts say. Fed Chair Jerome Powell said at a recent news conference that these purchases have helped market conditions improve “substantially” in recent weeks.

But an unstated, practical result of the Fed’s bond purchases is that it creates money to finance the gigantic debt run up by Congress.

The very idea of that tends to explode the heads of those who say dollars should come from work, savings and investment instead of thin air. In the age of a nearly $25 trillion national debt, such “sound money” concepts seem outdated — relics of a bygone era in which the value of a dollar once was based on a fixed amount of gold.

In this case, the federal government isn’t just creating massive amounts of dollars from scratch. The government also is, in effect, using those newly created dollars to pay down its debt, this time at an unprecedented scale because of the economy's massive shutdown triggered by the pandemic.

This might sound like a financial fantasy: You mean we can pay our credit card bills by pressing a button?

Yes, the government can, unlike people and businesses, although it’s a little more complicated than that. The larger question is whether it’s sound and sustainable.

The answer depends on whom you ask and how the process is managed.

How it works

The Federal Reserve doesn’t literally print paper dollars. That’s the job of the Treasury, which also collects taxes and issues debt at the direction of Congress. At this time of crisis, the Fed instead makes large asset purchases on the open market by adding newly created electronic dollars to the reserves of banks such as Wells Fargo, Goldman Sachs and Morgan Stanley.

In exchange, the Fed receives large amounts of bonds — U.S. Treasury securities and agency securities that are backed by bundles of home mortgages.

As a result, markets that had stopped working smoothly start to flow again. Banks get more dollars in reserve and are more prone to lend money without worrying about exhausting their funds because of a run on the bank. Such big purchases of securities by the Fed also effectively increase the money supply and drive down interest rates. This keeps borrowing costs cheap for those who need loans.

If the Fed didn’t take these and other emergency measures, “the system already would have blown up,” said Tim Duy, an economist at the University of Oregon who previously worked for the Treasury.

Separately, Congress recently has passed massive spending bills that have swollen the national debt by about $2.4 trillion to help businesses and taxpayers. Much of that money comes from issuing U.S. Treasury securities — government debt that is bought by investors who earn interest on it.

Foreign and domestic investors owned most U.S. public debt as of last year, with the Fed owning only 14% of it, according to the Government Accountability Office.

But since mid-March, the Fed has bought $1.4 trillion in Treasuries — the bulk of the $1.6 trillion in Treasuries issued during that period — to thaw out frozen markets, according to Oxford Economics. The Fed, however, doesn’t buy securities directly from the U.S. Treasury; instead, it buys previously issued Treasury securities through commercial banks.

In effect, one part of the government — the Fed — is creating dollars to buy government debt in the form of securities previously issued by the Treasury. The Treasury then pays the Fed what it owes in interest on those securities. In turn, the Fed is required by law to return to the Treasury the profit it makes from the Treasury on those securities.

“It’s just kind of a circle in that respect,” Duy said.

The same circle also plays a role in the Fed’s unprecedented crisis plan to lend more than $2 trillion to businesses and to state and local governments. In this case, the Fed also would be creating the money for loans, said former Federal Reserve Vice Chairman Alan Blinder, now an economics professor at Princeton.

Fed Chair Powell said he expects the loans to be repaid. But what if some aren't? Does it matter? After all, the Fed can just push a button to create money.

Blinder said it does matter because the Fed is required to remit to the Treasury the profits it makes on its balance sheet, which has ballooned by $2.2 trillion to a record $6.7 trillion since mid-March.

“If the Fed would take losses on some of its loans, it would pay less to the Treasury,” Blinder said. “The budget deficit would be higher, so it would be as if the Treasury spent more money or taxed less.”

This is why Congress, through the CARES Act relief and stimulus measure, also has provided $454 billion for Fed programs in case some loans fail, giving the central bank some political cover in case they do.

Inflation risk?

Paul, the former Texas congressman and author of “End the Fed,” predicts that such money creation will lead to disaster. He says it will cause overheated financial bubbles fueled by too much easy money in the system. Creating too much money that chases too few goods also leads to price inflation, decreasing the purchasing power of the dollar.

But high inflation didn’t materialize the previous time the Fed created money on a similar scale as part of its efforts to revive the economy during and after the Great Recession. To the contrary, an arguably bigger concern — then and now — has been persistently low inflation, which eventually could lead to deflation, or falling prices, that prompt consumers to put off spending, hurting the economy.

"With the economy so down, and inflation so low, the fears that these kinds of operations will lead to high inflation in the United States seem very farfetched," Blinder said.

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